Historically, as life expectancies expanded and there were public and corporate policies for older workers to retire, employers would create pension plans where the individual's retirement income liability was funded as a side-effect of employment. The funding could be made by the employer, the employee, or both. Typically in employer-funded plans, the amount of income provided was determined by a formula usually including years of service and income earned. Over time, there has been a shift from these Defined Benefit plans to Defined Contribution plans (in the U.S., like 401(k) Plans), where the income provided in retirement is not predetermined, but rather is the result of whatever contributions were made by the employee during his career, the subsequent returns on the invested contributions, and the method of withdrawal of those accumulated investments. In general, Defined Benefit plans had the benefit of simplicity for the employee, but suffered from lack of portability of the accumulated value to other employers or plans, and suffered from the risk of financial failure of the employer. Defined Contribution plans offered transparency (the assets are owned for the benefit of the individual employee) and control (the employee within limits can choose the timing and amount of contributions and withdrawals), but suffer in that the resulting retirement income cannot be planned with assurance.
The usual way to provide a future income given an amount of saved money now is with a deferred annuity: for a deposit (or premium) now, a series of payments is made in the future, where the amount, periodicity, and number of payments is defined in the deferred annuity contract or policy. The contract may also describe how the initial deposit accumulates returns until the first payment is made (accumulation period), and how the payment stream (payout period) relates to the deposit and accumulated investment returns. The returns may be at a fixed rate, or at rates varying with the returns experienced in defined investment portfolios, or based on formulas such as a stock market index. Similarly, during payout, the amount of payments may be fixed, may change at a fixed rate over time, may change by a formula such as an inflation index, or may change based on returns experienced in investment portfolios. The payments may be made for the lifetime of one or more individual persons, for a set number of periods, or a combination.
Deferred annuities usually have an option for the owner of the contract to choose whether to withdraw the accumulated deposit(s) with returns in a lump sum, or convert the value to annuity payments with a defined rate of conversion. The advantage is that, depending on the particular definition of accumulation and payout conversion, the owner can know at the time of the deposit what income will be provided in the future. In general, this is dependent on a fixed or guaranteed minimum return during accumulation, and a fixed or guaranteed minimum rate of conversion (i.e., for an annuitant at age 65 at conversion, each $1,000 of accumulated value can convert to, say, $6/month of income for as long as the annuitant lives). While many savers will appreciate the flexibility of the option to choose the lump sum or the annuity, the option imposes a set of costs and constraints, in particular, adverse selection. (Adverse selection is the phenomenon that the individual can choose to take the lump sum if he feels he knows that he will not live as long as the average life expectancy. Thus, the population of annuitants will be skewed to have a life expectancy longer than the general population, and this means that life-based annuity payments must be less than implied by the general population's life expectancy.)